Never waste a crisis

1 May 2020

The COVID-19 pandemic has created a state of extreme market volatility, with investors feeling significant anxiety and fear for their financial future. With global markets experiencing the fastest bear market on record, with the S&P 500 falling 34% from February highs, investors are racing to sell stocks and flocking to safe havens. But for investors who can keep a level head and stay the course, the current market presents attractive opportunities, especially in the global small and mid-cap (SMID) sector.

For almost 100 years in the US, SMID stocks have, on average, outperformed large caps. Fairlight defines the SMID sector as companies with a market capitalisation of US$500 million ($774.5 million) to $20 billion.

Historically, the global SMID sector has outperformed large caps by approximately 3% per annum. However, the sector is currently experiencing a set-back, trading at a significant discount due to investors shunning risk and looking to mitigate the near-term impact of the COVID-19 crisis. This has led to indiscriminate selling in the small cap sector, with small companies the cheapest they have been in a decade. This has created fantastic opportunities for investors to acquire quality companies at a significant discount to their intrinsic value and build a more robust and diversified portfolio. 

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The global SMID sector can be a more volatile asset class for investors, and taking a defensive, long only, quality approach to investing can help to minimise this risk.

Historically, size and quality have proven to blend beneficially. There has not been a period over the past 20 years that the small cap and quality factors have underperformed the MSCI Global ACWI index at the same time. For this reason, we suggest investors take a focussed, defensive approach for investing in the global SMID sector targeting quality companies with a proven track record. For example, the Fairlight portfolio consists of only 35 quality stocks and focuses exclusively on the healthcare, consumer staples, technology, and light industrials sectors. 

Considering risk is crucial when investing. Taking a defensive approach to a riskier asset class means designing portfolios that are robust during difficult times and can weather unexpected crises, such as COVID-19. 

To do this, we suggest investors avoid any companies or industries that are highly leveraged, such as banks and property, and to be wary of highly cyclical businesses such as oil and gas. Reviewing historical performance can also be a helpful indicator. We conducted a thorough analysis of the listed stocks held in the portfolio during the 2007-09 Global Financial Crisis (GFC), including share price performance, profit and loss analysis, capital raises, and dividend cuts. We found all the listed companies we are invested in performed well during the GFC, compared to the market, and there were no companies generating losses during that period. This defensive approach is once again proving successful, with Fairlight outperforming its index, the MSCI global small cap, and the MSCI large cap index by 450 basis points in March, the worst sell-off period during the COVID-19 crisis.

QUALITY AT THE RIGHT PRICE 

With so much market noise, it can be difficult for investors to spot an opportunity and understand where value lies in the market. When looking for opportunities it can be tempting to react to significant share price drops – who doesn’t love a bargain? But just looking at price and buying what is cheap can be a serious trap for investors. 

When evaluating stocks investors should avoid being reactionary and only invest in quality companies they know well. We maintain a ‘bench’ of businesses that are not currently in the portfolio – we know them well, have met management, covered the business for some time and have full financial models established, but the price hasn’t been right. Maintaining ongoing valuations for businesses means investors are well placed to move quickly and take advantage of market dislocations to acquire quality companies at attractive prices. 

But what if you are only just starting to look at stocks, where do you start? Understanding company fundamentals is crucial. Thorough screening, such as geography, business sector, financial resilience, and governance, can help to identify quality businesses that are undervalued. Questions investors should consider when buying during this crisis are: 

  • Does the business have a strong balance sheet? Will the company require a capital raising in the near term?
  • Do you know what is on the balance sheet? Investors should be wary of banking stocks which can be thought of as leveraged black boxes that are often at the heart of financial crises.
  • Are there recurring revenue streams, such as licensing fees, or is the business reliant on customers capex decisions that require approval from the board of directors or procurement team?
  • How did the business perform during the GFC, or other crises? Whilst the COVID-19 downturn differs markedly, there are some lessons to be gleaned from the previous downturn, especially regarding the strength of various business models. 

There has been a lot of discussion about identifying the bottom of the market and finding the right time to buy. In my opinion, company fundamentals are the most important factor to identify quality at the right price. Where we have identified those ‘bench’ businesses trading at notable discounts, we have judiciously started to buy. As a risk mitigation tool, we typically start averaging into a stock at a 1% holding, with our full position scaling to 4% to 5%. We feel exercising a patient, measured approach to investing ensures a solid understanding of the company and provides confidence we are investing in quality stocks that will deliver strong, sustainable returns.

Times like this call for a calm head and rational, informed decisions. Often investors can be overwhelmed by emotion, which causes some to panic sell at the worst time during a downturn. While we don’t know when the market will bottom, taking a sensible, well-researched approach can help investors make the most of opportunities currently presenting themselves.

SPOTTING AN OPPORTUNITY

Coming into this crisis, opportunities in the global SMID sector were limited and as a result the Fairlight fund was holding approximately 12% of its assets in cash. This meant we were well positioned to take advantage of the opportunities that arose due to the COVID-19 market sell-off. 

A stock we have acquired during this crisis is Nemetschek, a German software business operating in the design, building management, and maintenance market. This company has been sitting on our ‘bench’ for two years while we waited for the right price. When the share price dropped 37%, we seized our opportunity. 

Nemetschek has a 95% customer retention rate, strong pricing power, robust margins, and a disciplined management team, who we meet with regularly. Like us, they are looking for quality acquisition opportunities within adjacent niche markets that they can help scale globally. The business has a net cash balance sheet which will be deployed as vendor expectations become more realistic over the next few months.

Another quality stock we have purchased during this downturn is AspenTech. While we avoid the oil and gas and heavy industrials industry, we have some exposure through AspenTech, which provides design and maintenance software for this sector. The technology is so good that AspenTech insists on a five-year non-breakable contract with yearly price escalators. While we had a small exposure to this stock, we took the opportunity to increase our position when it traded down 46% from its peak. 

We have also moved quickly to exit stocks we felt were at risk or overvalued. These exits have allowed us to redeploy capital to increase the quality of the portfolio. 

Carmax, the largest used car dealership in the US was one example of this. It has an impressive, no-haggle pricing model and has been successfully taking market share over a sustained period of time. It has also moved to an omnichannel model, allowing digital transactions and delivery of vehicles to the purchaser’s doorstep. However, the business is dependent on the consumer finance market remaining open. As credit tightened, we decided to liquidate our position and redeploy the capital. 

Henry Schein, a steady distribution business serving the GP and dental market, was another stock we sold down. We believe that dentist practices will face a prolonged period of pressure on discretionary dental work, and with high fixed cost leverage due to distribution centres we felt the business would be disproportionately affected. 

MAKING THE MOST OF THE CRISIS 

Through analysing company fundamentals and taking a patient, defensive approach to investing, investors can take advantage of the current market opportunities and acquire quality businesses trading at a discount. However, this can be an emotive time for investors, which is why using professional fund managers may make sense in this environment. Churchill’s strategy is proving correct for opportunistic investors in the global SMID sector. It pays to be prepared for inevitable crises and act with courage and conviction so the opportunity does not go to waste.  

Nicholas Cregan is portfolio manager and partner at Fairlight Asset Management.




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